BARRON'S COVER
Treading Carefully
By JACK WILLOUGHBY
The bull is still in charge, say America's money managers in our latest Big Money Poll. But it pays to be cautious, as bargains are getting harder to find. The case for Microsoft.
AMERICA'S MONEY MANAGERS are still bullish about stocks, even after a blistering eight-month rally. But they also know from recent experience that trees don't grow to the sky, and bears don't disappear; they merely hibernate. So call our latest crop of Big Money bulls hopeful but cautious, too, about how much life is left in this rally, and how many bargains remain.
Nearly 60% of the professional investment managers responding to Barron's fall Big Money poll say they are bullish or very bullish about the stock market's prospects through the middle of next year. That's the same percentage of bulls as in our spring survey, and a sure sign the pros regarded the market as severely oversold when the Dow Jones Industrial Average fell to 6547 in early March -- a 12-year low.
Today's bullish investors see the major stock indexes making steady progress through next June, amid signs the U.S. economy is on the mend after a searing recession. The latest evidence came Thursday, when the government reported that U.S. gross domestic product grew 3.5% in this year's third quarter, spurred by stimulus spending. That is the first uptick in a year.
Based on the bulls' mean predictions, the Dow industrials could climb another 5% or so, to 10,187, by year end, en route to 10,771 by the middle of 2010. The Standard and Poor's 500 stock index could rally 8% in the next two months, to 1121, and another 6% through June, to 1190. Consistent with their fondness for technology shares, expressed elsewhere in the survey, they wager the Nasdaq Composite will do best, rising 15.9%, to 2371, from now through the end of next June.
Scott Pollack for Barron's
Yet, almost 80% of our respondents think stocks are fairly valued or overvalued today, compared with 44% who felt that way last spring. And nearly half say the chance of a sharp correction in coming months is 50% or greater. Should the market plummet anew, 46% of managers expect cash to offer the best refuge, while 27% plan to hide in Treasury bonds and 16% in gold.
THE BIG MONEY MANAGERS are a lot more enamored of overseas markets than U.S. stocks these days. Only 28% think ours will be the world's best performer in the next six to 12 months; 49% expect emerging markets to take the lead, while 19% are betting on developed markets in Asia. Almost 60% of poll participants say they're bullish on Asian stocks, while 54% say they are upbeat on Latin America.
A fondness for foreign shares doesn't sit so well with one bullish manager, however. "The U.S. is still the strongest country in the world," says Dave Hartzell, founder of Buffalo-based Cornell Capital Management, which oversees almost $70 million. "It is still the safest place to stash your cash."
Hartzell is keeping his clients' money close to home in the expectation the Dow will trade up to 12,000 by the middle of 2010. "There's still a lot of fear out there," he says, noting it creates opportunity for bargain hunters.
Since March, Connecticut money manager Jim O'Shaughnessy has argued that last year's crippling reversal in stocks has created "a generational opportunity" for investors. "The world must have looked pretty bleak to investors at the end of 1941," he says.
Head of O'Shaughnessy Asset Management, which oversees $5.1 billion, O'Shaughnessy predicts the Dow will end this year at 9975, before rising to 11,140 by mid-2010. His June '10 S&P target is 1200, and his Nasdaq target, 2625. He thinks equities could earn as much as 15% a year in the next five years, with "the junk rally ending and high-quality stocks taking the lead."
Charles Lemonides, another market bull and a principal at ValueWorks, a New York money manager that oversees $150 million, agrees that "it's really easy" to be optimistic these days. It's best to invest "in times of calamity," he says.
"Amid last fall's panic, price and valuation didn't matter. Consequently, the market still affords plenty of opportunities."
Lemonides has placed his bets on depressed pharmaceuticals stocks, and aerospace giant Boeing (ticker: BA). He sees the Dow climbing to 12,000 by next June, and predicts it could trade as high as 15,000 in "two or three years."
Those who compare the U.S. to Japan in the mid-1990s are "way off base," Lemonides maintains, as investment possibilities exist for U.S. banks that weren't available to Japanese banks in the 'Nineties. While he thinks U.S. policy makers lost credibility by first supporting Fannie Mae and Freddie Mac in 2007 and early '08, only to put the troubled mortgage giants into government receivership later, he credits Washington with doing "everything to reflate the economy," and sees evidence those efforts are working.
To Eric Green, a senior partner at Penn Capital Management in Philadelphia, which manages $4.5 billion in stocks and high-yield bonds, improved credit conditions are responsible for the market's recent gains. "The credit market has loosened up dramatically, foreshadowing higher stock prices and a better economy," he says. "We [could have] positive GDP growth in the fourth quarter. GDP predictions that were 1% have increased to 3% to 5%. Consumer confidence is up, and some say unemployment has reached its peak. Earnings have beaten expectations in 80% of cases. The last thing the government wants is a double-dip recession."
Green expects the Dow industrials to end this year at 11,000, and tack on another 1500 points by next June. He thinks the S&P could trade up to 1210, and the Nasdaq to 2500 by mid-2010. The Dow closed Friday at 9712.13, the S&P 500 at 1036.19 and the Nasdaq Composite at 2045.11.
POLL PARTICIPANTS EXPECT three industry sectors to outperform in the next six to 12 months: technology, energy and health care. Concerns about the potential impact of health-care reform don't seem to scare this crowd. Among subgroups, they favor metals and mining stocks, and coal, natural gas and pipeline concerns. The managers say they're bullish to neutral on oil, and expect crude prices to stay elevated at around $70 to $75 a barrel.
As for the poorest performers, the managers finger financials and consumer-cyclical shares. That's not surprising, as the list of bank failures keeps growing and some of the nation's largest banks continue to struggle to get their finances in order, even with a helping hand from Uncle Sam. Much like the banks, consumers binged on debt in recent years, and there's little reason to think they'll be loading up in coming months on discretionary goods.
From Microsoft (MSFT) to CVS Caremark (CVS), Abbott Laboratories (ABT), Berkshire Hathaway (BRK-A) and Goldman Sachs (GS), the managers' favorite stocks have one thing in common: These companies generate mountains of cash. Our respondents' top pick, Microsoft has rallied nicely since March, but substantial gains could lie ahead as the software titan embarks on a new product-upgrade cycle, headlined by the launch of the Windows 7 computer-operating system, which has garnered glowing reviews.
Microsoft trades for 15.5 times the $1.79 it is expected to earn in the fiscal year ending next June. Back out the company's nearly $4 a share in cash, and its price/earnings multiple is only 13. Microsoft returns cash to shareholders via a 52-cent annual dividend; it yields 1.8%.
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Qualcomm (QCOM) is another tech bargain—and manager favorite. One Big Money manager expects the company to earn $2.36 a share in the next 12 months, which implies a P/E of 17.5—well below its five-year average forward P/E of 22, he says. Qualcomm boasts operating margins of 35%, and pays a dividend of 68 cents, for a yield of 1.6%. A maker of cellphone chips, it is gaining market share in the 3G (third-generation) handset market.
Cornell Capital's Hartzell is a fan of General Electric (GE), yet another top pick. It trades at about 14, but based on his sum-of the-parts valuation, it could be worth as much as 25. At the height of the credit crisis, amid concerns about its financial health, GE sold for under 6 a share. Hartzell also likes eBay (EBAY), now at 22.27. It recently sold a majority stake in Skype, the maker of popular computer calling software. Hartzell figures eBay's retained interest in Skype is worth several dollars per share, and that eBay itself is worth 30.
Lots of tech companies, from Apple (AAPL) to Google (GOOG) to Yahoo! (YHOO), also dot the list of stocks our respondents consider most overvalued. Amazon.com (AMZN) is there, too; it trades for an impressive 63 times next year's expected earnings.
The managers think Citigroup (C) is priced too richly, now that its stock has more than quadrupled, to 4.09 a share. But they say no stock is as overvalued as that of insurer American International Group (AIG), which was bailed out by the government last year to the tune of $180 billion. AIG now trades at 33.62, up from a 52-week low of 6.60. Says one bear, "It's simple: The money AIG owes the government is way above the collective value of the company. It is likely there will be nothing left for shareholders."
THE BIG MONEY POLL is produced twice yearly by Barron's, in the spring and fall, with the help of Beta Research in Syosset, N.Y.
The latest survey elicited responses from 111 money managers from across the U.S. Some are sole proprietors, while others manage billions of dollars for pensions, mutual funds and hedge funds. The poll was e-mailed to investors in late September, when the Dow was around 9900, the S&P was 1050 and Nasdaq was 2100.
Thirteen percent of those responding to our fall poll say they are bearish about the stock market's prospects through next June, while 28% say they're on the fence. These percentages, too, mirror last spring's results. The Big Money bears see stocks falling around 10% through the middle of next year. The Dow could end this year at around 9550, they say, before tumbling to 8776 in the first half of 2010. The S&P 500 could retreat to 922 by June, while the Nasdaq could land at 1823.
Ed Long, a principal at Greenwich, Conn.-based Gillespie, Robinson and Grimm, which manages $750 million, puts himself firmly in the bearish camp. He sees the Dow ending this year at 9000, and next June at 8300. His S&P forecast for mid-2010—880—also is well below the mean. "This market has risen too far, too fast," says Long, who worries about the economy's strength. He notes that credit remains tight for small businesses, while home buyers now must put down a lot more cash in order to secure a mortgage.
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Long is buying stocks he considers undervalued, while also conserving cash to use in the coming decline. CVS Caremark is one of his favorites; it trades for 35.30, or 14 times expected earnings. CVS, based in Woonsocket, R.I., is a pharmacy-benefits manager disguised as drugstore retailer, he says. As such, it is worthy of a much higher price/earnings multiple. He expects earnings to grow by 8% to 10% in the next three years. CVS netted $2.18 a share last year, and analysts have penciled in $2.63 a share for 2009.
Long is wary of miner Freeport McMoRan Copper & Gold (FCX), whose shares have shot up more than 150% this year, to a recent 73.36. Even though 57% of the Big Money managers think commodities prices will continue to rise in the next six months, Long suspects that materials stocks will come under pressure after a good run.
Gold, the prom queen of commodities this year, doesn't excite most Big Money managers at its current price. Only 36% say they're bullish about the yellow metal, which has rallied about 35% in the past 12 months, to $1,039.70 an ounce. It peaked in mid-October at a high of $1,064.20.
Robert Medway, co-founder of New York based Royal Capital, which manages $1.6 billion, is a fan, however. His Armageddon hedge against hyperinflation, which he views as the inevitable outcome of current government policy, is to buy gold and sell government securities short. Medway thinks gold could trade as high as $1,850 an ounce by the middle of next year.
Bearish on the stock market, Medway sees a correction coming; he's just not sure when. He expects the Dow to reach 11,200 before the downturn begins, which will carry the average all the way back to 6500, below even its March trough. Downside for the S&P 500 could be 550, and for the Nasdaq, 1490, although the arc of the decline might take a number of years.
Debt has fueled the economy's growth and the consumer's spending power, and "the only way to recover is by issuing even more debt," he says. "That eventually will lead to hyperinflation. Otherwise, we'll do a long, slow slog, as the Japanese have done."
Amid the financial crisis of the past two years, "fiscal responsibility has gone out the window," he charges. "The U.S. is spending $1.76 for every $1 we collect. As a percentage of GDP, deficit spending is the largest it's been since World War II. GDP growth of 3.5% is not sustainable."
Medway says the policies of President Barack Obama's administration have muted the "bust" phase of the business cycle, but lengthened it. "Delevering is the only way to correct today's imbalances," he says.
LAST SPRING, THE BIG MONEY managers thought stocks would be most apt to rally on any sign of a thaw in the nation's frozen credit markets. Now that credit is flowing a bit more generously, the crowd has turned its attention to a potential pick-up in earnings. Almost 40% of poll participants say higher profits could be the spark that ignites the next leg of the rally.
The managers predict S&P 500 operating profits will grow by 6% to 7% this year, and by more than 15% in 2010. The Wall Street consensus calls for S&P operating profits to drop about 10% this year, but rise about 23% in 2010.
About 75% of poll participants think the decline in U.S. profits has ended, while 82% of that group believe the earnings rebound is sustainable.
"All the bottom-up models show some compelling earnings are due by the middle of next year," says Douglas McEldowney, senior portfolio manager of the Northern Trust Large Cap Value Fund (NOLVX), with $249 million of assets.
"Companies have cut expenses much faster and much deeper than in the past. That means any increase in revenue will drop to the bottom line faster than in the past. What's going to make this drive come alive is a return of the consumer."
A confirmed bull, McEldowney expects the DJIA to rise to 11,600 by the middle of next year, with the market's other measures keeping pace. "We find all this pessimism works to our advantage," he says.
A pickup in earnings goes hand-in glove with the stronger economy that our respondents and many others see. Some 72% of managers say the recession has ended, while 52% see no chance of a "double dip," or second leg down. That said, a third put the odds of another recession at 75% or greater.
Third-quarter GDP growth beat estimates, which likely will lead economists and others to ratchet up their fourth quarter forecasts. Roughly half the Big Money folks, completing surveys in recent weeks, think the economy can expand by 3% to 4% in the October-December span.
So far, the Federal Reserve has given no indication it sees any need to raise interest rates from near-zero levels. That could change in coming months, however, if the economy gathers more steam. Just over 50% of the managers expect Fed Chief Ben Bernanke to tighten credit in the next 12 months in an effort to stave off inflation; however, 47% think the U.S. central bank will leave rates unchanged. The Fed has been targeting short-term rates of 0% to 0.25% since December.
To the Big Money managers, inflation is by far the greater threat than deflation these days; 71% are more concerned about the possibility that prices will rise, not fall. Yet, it might not be that simple, suggests Brad Brooks, senior portfolio manager with Value Line Asset Management, which handles $2.5 billion. Overvalued real-estate assets held on the books of major banks, which no longer have to mark them to market, have been "propped up" and not allowed to deflate, Brooks says.
"We face certain deflationary problems in sectors like residential and commercial real estate, but inflationary headwinds in other areas like health care, education and potentially food and energy," he says.
MANY ON WALL STREET and Main have blamed the Fed's easy-money policies for creating bubbles in equities, real estate and other arenas in recent years. Perhaps it's of some comfort that a majority of poll respondents—56%, to be exact—don't see another asset-price bubble brewing in the economy or financial markets.
And what of the 44% who do? Most fear the biggest bubble is building in the Treasury market, where yields have plummeted and prices soared. "Central-bank liquidity programs have directly and indirectly contributed to growing bubbles in financial assets," wrote one poll participant. "Global equity prices are again above intrinsic value, and in a world that will see the deleveraging of private-market debt over the next decade or more, credit spreads are again far too tight."
Another respondent put it simply: "The 30-year Treasury is very dangerous."
A third noted, "Gold is a crowded trade and Treasuries are artificially high. If gold has glittered in 2009, the dollar's done anything but. The fact that "government-backed debt is being issued like Monopoly money," as one investor wrote, has hurt the buck relative to other currencies, and many, but not all, Big Money managers expect the pain to continue. Some 53% see further losses against both the yen and the euro.
The Big Money men and women overwhelmingly discount talk that the dollar could lose its reserve-currency status, at least in the next five years; indeed, 92% say that won't happen. "We see a dilution of the dollar in the total of reserves held, but not a major diminution," one manager advised.
Yet, 44% of poll participants think the buck could be demoted within 10 years. "The possible collapse of the dollar over the long term is a big worry, given our monetary and fiscal policies," says Ron Doyle, head of equity investment at Meadow Brook Investment Advisors in Livonia, Mich.
SOME MARKET WATCHERS SAY the ailing dollar is a referendum on the Obama administration's handling of the nation's financial crisis. Our correspondents aren't thrilled with the government's actions either; 65% say they disapprove of the administration's moves to date. "Fiscal stimulus created a $1.4 trillion deficit with no evidence of contribution to job growth," one manager wrote in the Comments section of the survey. "Pursuing another large government entitlement program—health-care reform—is a disaster in the making."
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Others would like to see better regulation of the financial markets, in particular "real regulation of derivatives and hedge funds. Without better oversight, we will have the same problems again, and quite soon, perhaps," one manager wrote.
Yet, the investment managers also have praise for the major players in this high-stakes drama: "We think the Fed (as well as other central banks) has done an admirable job in a very difficult circumstance, and that it was the Fed that, as the lender of last resort, helped restore confidence in the financial system," one money manager wrote. "For the Obama administration, the stress tests [of big banks] also likely added to confidence and were a positive."
Notwithstanding the magnitude of this year's rally, nor evidence of a nascent economic revival, the managers don't plan too many asset-allocation changes in their portfolios in the next 12 months. On average, they plan to nudge up their equity holdings to 73% of assets, from today's 72%, while trimming cash to roughly 7.6% from a current 9.2%.
IF HIGHLY SPECULATIVE STOCKS, including big bank shares, fueled much of this year's rally, the Big Money managers see a shift to high-quality issues looming. Roughly 22% say U.S. large-cap-value stocks will do best in the next six to 12 months, while the same percentage are banking on U.S. large-cap growth.
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Lower-quality stocks are pushing credibility, says Scott Schermerhorn, a principal with Granite Investment Advisors, a Concord, N.H.-based money manager with $480 million in assets. "Why should I pay up for speculative earnings in the future when I can buy high-quality, large-cap companies with earnings right now?" he asks.
Tim Call, a portfolio manager at The Capital Management Corporation in Glen Allen, Va., which handles $200 million, makes a similar point. Call says he's moving into high-quality growth stocks such as Cisco Systems (CSCO), Oracle (ORCL) and Microsoft, as these companies generate earnings and cash flow.
Call is bullish about the market; he sees the Dow rising to 10,500 by Christmas and 11,000 by next June. In particular, he's heartened by the Federal Reserve's pledge to continue buying Fannie Mae and Freddie Mac mortgage-backed paper, as he thinks the central bank's presence in the market will keep risk premiums down and aid stocks.
Barron's will survey the nation's money managers again next spring. By then, we'll know if the economy is back in triage or truly on the mend. For investors, much will hinge on the matter of a double dip, and whether more companies— and even consumers—can get back on their feet without a crutch from the White House.
If the managers were right this fall, stocks will be higher six months hence. But for savvy stock pickers, opportunities will remain.
Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved
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